3 Things You Need To Know When Picking A Country ETF

International investing has earned its place in portfolio construction, as both academic studies and real-world experience have supported the idea that investing outside the United States can improve returns and actually reduce risk and volatility. Investors have a wealth of choices when it comes to using ETFs for international exposure, as there are over 400 equity ETFs that focus on non-U.S. investments [Download How To Pick The Right ETF Every Time].

One particular option for investors looking to use ETFs to gain international exposure is the country-specific fund. As the name indicates, these funds focus on holding the equities of companies that are domiciled in the country or conduct substantial operations in that country. As such, they are "hyper-focused" on the country [Try the Free ETF Country Exposure Tool].

While country-focused ETFs may seem relatively straightforward, there are three major considerations that investors must examine prior to buying such a fund.

1. How Pure Is The Play?

A country-specific ETF may well include many stocks of companies that are headquartered in the country, but that does not necessarily mean that the performances of those companies are tied to fundamentals within that country.

Likewise, the FTSE Argentina 20 ETF (ARGT, C+) has some rather curious holdings with respect to how they reflect the economic and financial conditions of Argentina. Tenaris (TS) is the largest holding of this fund, and while it does have meaningful operations in Argentina, the company is headquartered in Luxembourg and generates 84% of its revenue outside of South America. Likewise, other major holdings like Mercadolibre (MELI), Arcos Dorados (ARCO) and Goldcorp (GG) generate only a portion of their revenues in Argentina, and their performance does not necessarily reflect the performance of the Argentine economy or stock market.

Investors should also be wary of situations where ETF allocations may accurately reflect a country's economy, but still constitute some diversification risk. The economies of both South Korea and Taiwan do depend to a large degree on the manufacturing and export of technological products, and the respective ETFs reflect this with some allocating more than half of total assets to the sector. It can be argued that the health of the global IT market does have direct bearing on the local economies, as so many citizens are employed in these industries and those companies contribute to the economy in significant ways, but others may feel that they do not accurately reflect the development of the local economies.

2. How Diverse Is the Market?

Another key issue with country-specific funds is the makeup of the investable universe. This can be a byproduct of the underlying economy, the maturity of the public financial markets, or both. In either case, investors should consider the risk that the investable market (and by extension the ETF) either does not adequately reflect the underlying economy or that it compromises growth and diversification potential too significantly [see China ETFs: Closer Look Under The Hood].

In many cases, banks were among the first companies to offer publicly-traded shares in their home market. What's more, many of these companies have legacies as either government-owned entities or legal oligopolies, which allowed these companies to get very large in terms of assets and market capitalization, overweighting them relative to other industries and companies. Below, look at some top country ETFs, and see much they have allocated to one sector or holding:

3. Consider the Cap

Investors should also consider the size (typically best represented by market capitalization) of the stocks in a fund as a reflection of how accurately the fund reflects local conditions. In many cases, large emerging market companies have grown large by becoming international players and, typically, large producers of commodity products. Accordingly, their performance may not reflect the underlying conditions or growth within the home country.

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Major components of the MSCI Brazil Index (EWZ, B+) like Vale, Petrobras and Gerdau generate substantial amounts of their revenue by selling commodity products outside of Brazil. Likewise, many of the large companies included in other emerging market ETFs like MSCI Thailand (THD, A) and MSCI Malaysia (EWM, A) are large global entities with substantial out-of-country revenues and assets [see Small Cap ETFdb Portfolio].

More often, smaller companies (like those included in MSCI Brazil Small Cap (EWZS, A-)) are built around serving the local market and are more of a pure play on the local economy. As such, they can offer considerably more growth potential than large, mature financial services companies or commodity producers. On the other hand, their size and local exposure also tend to mean more volatility and more risk.

It's worth noting, though, that small cap exposure is not necessarily a guarantee of diverse industry exposure. MSCI Japan Small Cap (JSC, A-) and Germany Small Cap (GERJ, C+) are well-diversified funds that include companies with substantial local exposure, as opposed to the multinational-heavy, larger-cap country ETFs. But the Indonesia Small Cap ETF (IDXJ, n/a) is actually even more heavily weighted towards financial services and energy than the larger-cap ETFs.

The Bottom Line

Country-specific ETFs do offer an opportunity to invest in countries that would otherwise largely be out of reach for regular investors, and they offer almost instant diversification. That said, not all country-specific ETFs are created alike, and investors should examine the holdings to make sure they are getting the sort of exposure they really want [see How Balanced Is Your BRIC ETF?].

While it is true that local banks and financial service companies generally do perform in line with the broader economy, a heavy weighting of multinationals or companies that garner substantial revenue outside the home country can distort performance. These issues tend to resolve as markets mature and grow, but investors are well served to double-check the holdings of country-specific ETFs and make sure that they line up with their goals and expectations.